UNITED STATES OF AMERICA
Before the
SECURITIES AND EXCHANGE COMMISSION
Investment Advisers Act of 1940
Release No. 1653 / September 2, 1997
Accounting and Auditing Enforcement
Release No. 948 / September 2, 1997
ADMINISTRATIVE PROCEEDING
File No. 3-9382
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:
In the Matter of :
: ORDER INSTITUTING PUBLIC
: PROCEEDINGS, MAKING
S. DONALD SUSSMAN : FINDINGS, CEASE-AND-DESIST
: ORDER, AND ORDER IMPOSING
: REMEDIAL SANCTIONS
Respondent. :
:
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I.
The Securities and Exchange Commission ("Commission") deems it
appropriate and in the public interest to institute public administrative
proceedings pursuant to Sections 203(f) and 203(k) of the Investment
Advisers Act of 1940 ("Advisers Act"), against S. Donald Sussman
("Sussman").
In anticipation of the institution of these proceedings, Sussman has
submitted an Offer of Settlement (the "Offer") to the Commission, which the
Commission has determined to accept. Solely for the purpose of these
proceedings and any other proceedings brought by or on behalf of the
Commission or in which the Commission is a party, and without admitting or
denying the findings contained herein, except as to the Commission's
jurisidiction over him and over the subject matter of this proceeding,
which is admitted, Sussman has consented to the entry of the findings and
remedial sanctions set forth below.
Accordingly, IT IS ORDERED that proceedings pursuant to Sections
203(f) and 203(k) of the Advisers Act be, and hereby are, instituted.
II.
On the basis of this Order Instituting Public Proceedings, Making
Findings, Cease-and-Desist Order, and Order Imposing Remedial Sanctions
("Order") and the Offer, the Commission makes the following findings:
RESPONDENT
A. Sussman was registered with the Commission as an investment
adviser pursuant to Section 203(c) of the Advisers Act from February 22,
1988, until March 24, 1994, when he voluntarily withdrew his registration
by filing a Form ADV-W. Sussman's principal place of business is
Greenwich, Connecticut. One of Sussman's investment advisory clients is
Paloma Partners, L.P. ("Paloma Limited"), to which he provides advisory
services in his capacity as the general partner of Paloma Limited. As of
December 31, 1993, Paloma Limited had assets of approximately $1.5 billion.
INTRODUCTION
B. This proceeding involves two different violations of Section
206(2) of the Advisers Act. The first violation concerns Sussman's failure
to provide adequate disclosure regarding potential conflicts of interest
arising from his purchase of a building using funds borrowed from Paloma
Limited. The second violation concerns Sussman's failure to charge certain
employee bonuses as expenses in the year in which those expenses were
incurred.
THE BUILDING PURCHASE
C. In or about April 1991, Sussman, through Lamda Capital Holdings,
Ltd. ("Lamda Holdings"), a corporation Sussman wholly owns, purchased a
building located at 99 River Road in Cos Cob, Connecticut ("99 River
Road"), for $2.3 million. Sussman purchased 99 River Road to house the
operations of Paloma Limited and other entities advised by or affiliated
with Sussman.
D. Sussman personally made the $230,000 down payment. He borrowed
the remaining $2.07 million from Paloma Limited to make the purchase (the
"Initial Loan"). Sussman authorized this loan in his capacity as general
partner of Paloma Limited. The Initial Loan was listed as a receivable due
to Paloma Limited in its general ledger, but there was no formal loan
documentation setting forth the Initial Loan's terms or providing Paloma
Limited with a security interest or any other interest in 99 River Road.
Legal title to 99 River Road was, and is, held by Lamda Holdings. Although
Sussman later stated that it was his intention that Paloma Limited would
receive any gain, or bear any loss, on a resale of 99 River Road, there was
no contemporaneous documentation reflecting such terms.
Throughout the relevant period, Sussman conducted his
advisory business through a sole proprietorship, known
as Paloma Partners Management Company ("Paloma
Management").
======END OF PAGE 2======
E. At the time of the purchase, the Amended and Restated Limited
Partnership Agreement of Paloma Partners, L.P. dated as of December 1, 1988
(the "Partnership Agreement") was in effect. Pursuant to the Partnership
Agreement, Sussman, as Paloma Limited's general partner, had "full and
complete charge of all affairs of the Partnership, and the management and
control of the Partnership's business and its assets shall rest exclusively
with the General Partner, subject to the terms and conditions of this
Partnership Agreement." The Partnership Agreement's statement of the
partnership's purpose included the ability to "transact such other business
as shall be necessary, advisable of [sic] incidental to the business of the
Partnership, all as determined by the General Partner." The Partnership
Agreement neither specifically authorized nor prohibited Paloma Limited
from lending money to Sussman.
F. In December 1991 Lamda Holdings obtained a mortgage on 99 River
Road from a commercial bank. Lamda Holdings used the entire $2.05 million
in mortgage proceeds to repay most of the Initial Loan in December 1991.
Lamda Holdings made no interest payment to Paloma Limited. Sussman
provided the mortgagee-bank with a personal guaranty on the mortgage.
Sussman never disclosed the Initial Loan, its terms, or its repayment to
the limited partners of Paloma Limited.
G. Lamda Holdings rented 99 River Road to Paloma Limited. The
parties have operated under a ten year lease that is dated as of April 30,
1991, but was never executed. The lease is a "triple net lease," which
means that Paloma Limited bears all the expenses of running the building,
including the costs of any mortgage interest and improvements to the
property. Actual rental payments did not commence until January 1992,
after the bank mortgage was in place. The operations of Paloma Limited,
Sussman's other advisory clients and Paloma Partners Management Company, a
Delaware Corporation ("Paloma Delaware"), were moved from New York City to
99 River Road in late 1991 or early 1992. Rent expense was
allocated among the investment advisory clients housed at 99 River Road.
H. During 1991 and early 1992, Paloma Limited loaned Lamda Holdings
an additional $700,000 to make improvements to 99 River Road. Sussman
authorized this loan in his capacity as general partner of Paloma Limited.
Paloma Limited has made other payments on Lamda Holdings' behalf related to
99 River Road, including the quarterly mortgage payments to the bank. The
amount of money Lamda Holdings owed to Paloma Limited has been reduced by
the monthly rent payments due to Lamda Holdings on the triple net lease.
The cumulative amount due and owing from Lamda Holdings to Paloma Limited
(the "Lamda Receivable") was approximately $1.1 million as of June 30,
1995. The amount due does not include any interest charge. There was no
agreement concerning when or how this receivable would be repaid.
Paloma Delaware provides administrative services for
Sussman's advisory clients, including Paloma Limited.
Paloma Delaware's expenses, including rent expenses,
are allocated and charged to the investment advisory
clients.
======END OF PAGE 3======
I. As of year end 1991, the Lamda Receivable was approximately
$870,000. Paloma Limited's audited financial statements for the year ended
December 31, 1991, did not separately disclose the existence of the Lamda
Receivable; it was instead included in the more general category of "Other
Assets".
J. The first time that any specific information concerning the Lamda
Receivable was disclosed to the limited partners was in a footnote to
Paloma Limited's financial statements for the year ended December 31, 1992,
as follows:
Included in other assets is a receivable arising from the
reimbursement of various expenses of approximately $893,000 from
a company owned by the general partner.
K. In the financial statements for the year ended December 31, 1993,
the footnote disclosure to the limited partners regarding the Lamda
Receivable was changed to read as follows:
[Sussman] owns a company which owns a building occupied solely by
[Paloma Limited] and related limited partnerships. Included in
other assets is a demand loan of approximately $963[,000] as of
December 31, 1993, that [Paloma Limited] has made to this
company. It is the intention of [Sussman] that any gain
recognized on the disposition of the building will inure to
[Paloma Limited].
This was the first time that Sussman communicated to the limited partners
an intention to pass on any benefit from the sale of 99 River Road to
Paloma Limited. There is no document that formalizes a legal obligation
from Sussman to provide this benefit. The financial statements do not
discuss what entity will bear the risk of loss on resale.
L. Paloma Limited, and the operations of related entities, moved out
of 99 River Road in or about October 1994. Paloma Limited and the related
entities continued to pay rent to Lamda Holdings for 99 River Road.
M. In the financial statements for the year ended December 31, 1994,
the footnote disclosure to the limited partners regarding the Lamda
Receivable stated as follows:
[Sussman] owns a company which owns a building rented solely by
[Paloma Limited] and some subsidiaries. Included in other assets
is a demand loan of approximately $1,036[,000] as of December 31,
1994, that [Paloma Limited and subsidiaries] has made to this
company. It is the intention of [Sussman] that any gain
recognized on the disposition of the building will inure to
[Paloma Limited].
N. Each year, Sussman signed a certification accompanying Paloma
Limited's financial statements, which stated, "To the best of the knowledge
======END OF PAGE 4======
and belief of the undersigned, the information contained in the audited
financial statements of [Paloma Limited] . . . is accurate and complete."
THE BONUS ACCOUNTING
O. At year end 1992, Paloma Limited and Paloma Partners Holdings,
L.P. ("Paloma Holdings") paid bonuses to certain key employees. Half of
each bonus was for work done in 1992, and the other half was a prepayment
of bonuses for 1993.
P. This entire bonus payment was included as a prepaid asset in the
financial statements for the year ended December 31, 1992, for Paloma
Limited and for Paloma Holdings, a limited partnership through which a
substantial portion of Paloma Limited's assets were invested. Paloma
Holdings' results of operation have a dollar for dollar effect on Paloma
Limited's results. Of the bonus payment, $3.6 million was recorded as an
asset of Paloma Limited and $3.1 million as an asset of Paloma Holdings.
Q. The entire bonus payment was charged as an expense in 1993.
Because half the bonus was for 1992 work, that half should have been
charged as an expense in 1992. Failure to do so meant that the 1992 Paloma
Limited financial statements understated operating expenses, and
consequently overstated income, by $3.35 million. If stated accurately,
operating expenses would have increased from $5.7 million to $8.9
million; net income would have declined from $81 million to
$77.65 million; and the rate of return for investors in Paloma Limited
would have declined from 11% to 10.6%.
R. Sussman signed a certification accompanying the financial
statements that stated, "To the best of the knowledge and belief of the
undersigned, the information contained in the audited financial statements
of [Paloma Limited] for the year ended December 31, 1992 is accurate and
complete."
S. Sussman either directed that the entire bonus be charged as a
1993 expense or acted with reckless disregard as to whether the bonus was
so charged.
III.
LEGAL ANALYSIS
Because the salary of one of the employees who received
a bonus was charged to Paloma Holdings in 1992, his
bonus of $150,000 also should have been charged to
Paloma Holdings. Thus, expenses for Paloma Limited
were understated by $3.2 million, not $3.35 million.
The full $3.35 million would nevertheless have been
reflected in Paloma Limited's overall net income and
rate of return.
======END OF PAGE 5======
A. Section 206(2) establishes a statutory fiduciary duty for
investment advisers to act for the benefit of their clients. Transamerica
Mortgage Advisors, Inc. v. Lewis, 444 U.S. 11, 17 (1979); Chancellor
Capital Management, Inc., Investment Advisers Act Rel. No. 1447, 57 SEC
Docket 2489, 2500 (Oct. 18, 1994). This fiduciary duty includes the duty
to exercise the utmost good faith in dealings with clients, to disclose all
material facts, and to employ reasonable care to avoid misleading clients.
SEC v. Capital Gains Research Bureau, Inc., 375 U.S. 180, 194 (1963);
Chancellor Capital, 57 SEC Docket at 2500. Actual injury is not required
for a Section 206(2) violation. Capital Gains, 375 U.S. at 192. An
investment adviser's failure to disclose a material conflict of interest
violates Section 206. Id. at 194. Proof of scienter is not required to
establish a violation of Section 206(2). Id. at 195.
B. An investment adviser has a duty to disclose to clients all
material information which might incline an investment adviser consciously
or unconsciously to render advice which is not disinterested. Id. at 191-
92. See Kingsley, Jennison, McNulty & Morse, Inc., Investment Advisers Act
Rel. No. 1396, 55 SEC Docket 2434, 2441 (Dec. 23, 1993) ("An adviser has a
duty to . . . disclose information that would expose any conflicts of
interest. Indeed, disclosure is required even where there is only a
potential conflict.")
C. Sussman violated Section 206(2) in the following manner. As to
99 River Road, Sussman failed to disclose the Initial Loan that enabled him
to buy 99 River Road for his wholly-owned corporation and the potential
conflicts of interest that resulted. Sussman's interests were in potential
conflict with those of his clients in that the documentation concerning the
building indicated that Sussman was now Paloma Limited's landlord and stood
to profit on any resale of the building, even though Paloma Limited had
loaned to Sussman, interest free, the money needed to purchase the
building. This conflict created a risk that Sussman's decisions regarding
99 River Road would not be disinterested and that the arrangement at 99
River Road might as a result be less favorable to Paloma Limited than an
arrangement reached at arms' length with a third party would be. Sussman
should have disclosed these potential conflicts to the limited partners of
Paloma Limited. Sussman's subsequent statement in the Paloma Limited
financial statements that he intended for the limited partners to benefit
on resale did not inform them that there were no formal documents legally
binding Sussman to provide them with this benefit. Sussman also failed to
inform the limited partners that they were at a risk of loss if there were
insufficient funds from a resale to enable Lamda Holdings to repay the
mortgage or the Lamda Receivable. Information concerning these potential
conflicts of interest and Sussman's use of Paloma Limited's funds for his
own benefit would be material to a limited partner.
D. With respect to the bonus expense accounting, Sussman violated
Section 206(2) by failing to charge $3.35 million in expenses in 1992,
which resulted in a 36% understatement of operating expenses. If it had
been charged in 1992, it would have reduced the investors' rate of return
for the year from 11% to 10.6%.
======END OF PAGE 6======
IV.
As a result of the foregoing, Sussman willfully violated Section
206(2) of the Advisers Act.
V.
In view of the foregoing, it is in the public interest to impose the
sanctions specified in the Offer of Settlement.
Accordingly, IT IS HEREBY ORDERED that Sussman:
A. shall cease and desist from committing or causing any violation
and any future violation of Section 206(2) of the Advisers Act;
B. shall, within ten days of any sale of 99 River Road, disgorge to
Paloma Limited any net profits earned on such sale;
C. shall comply with his undertakings, as specified in his Offer of
Settlement:
1. not to impose on Paloma Limited any losses incurred in
connection with the resale of 99 River Road;
2. not to impose on Paloma Limited any future costs of future
capital improvements, if any, to 99 River Road; and
3. within ten days of any sale of 99 River Road, to pay any
remaining indebtedness due from Lamda Holdings to Paloma
Limited; and
D. shall, within ten days of the date of this Order, pay a civil
money penalty in the amount of $40,000 to the United States Treasury. Such
payment shall be: (1) made by United States postal money order, certified
check, bank cashier's check or bank money order; (2) made payable to the
Securities and Exchange Commission; (3) hand delivered or mailed to the
Office of the Comptroller, Securities and Exchange Commission, 6432 General
Green Way, Stop 0-3, Alexandria, VA 22312; and (4) submitted under cover
of a letter which identifies Sussman as a Respondent in these proceedings,
the file number of these proceedings, a copy of which cover letter and
money order or check shall be sent to Daniel J. Goldstein, Assistant
Regional Director, Northeast Regional Office, Securities and Exchange
Commission, 7 World Trade Center, 13th Floor, New York, NY 10048.
The Commission notes that, subsequent to the
commencement of this investigation but prior to entry
of this Order, 99 River Road was sold and Sussman paid
off all remaining indebtedness to Paloma Limited.
There was a loss on the sale, and Sussman personally
bore that loss.
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By the Commission.
Jonathan G. Katz
Secretary
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